Thursday, 27 September 2012

"On the Fund’s part, we are favorably considering that this be done in as timely and flexible a manner as possible: slowing the pace of fiscal adjustment where needed; focusing on measures rather than targets..."

Success of this strategy relies on the level of confidence and consensus on "measures". One possibility is to express the targets in intervals that reflect the uncertainty on "measures". By settling on the level of uncertainty we could gain flexibility and accept the realization of a slower path of adjustment.

Now that the government gave up
on the idea of fiscal devaluation and decided to fall back on fiscal
consolidation and, more recently, poetry, the press is awash with speculation about the
raft of alternative fiscal measures to be introduced in the new budget. Some time ago I commented on the remarkable similarities between our current financial
problems and what arguably was our most serious financial crisis in modern
times – the 1892 default. After attempting to do something completely
different, the government now seems constrained by the corset of short-term
fiscal expediency that requires immediate tax increases (perhaps with increased progressivity) and expenditure cuts where feasible, though not necessarily more
efficient.

Reading the press, I was struck
once more by how the likely options of this government resemble the choices
followed in 1892. Maybe there was no learning over 120 years of public finance
in Portugal – or perhaps the co-dependency relation between state and economy,
very obvious in the nineteenth century, is essentially still there today.

The Portuguese government backed down from the proposed measure to increase employee's social
security contributions and decrease
employers' contributions. A measure that manages to elicit the opposition of the Portuguese left-wing parties, the unions, employers' associations, the American Enterprise Institute, and the Wall Street Journal is certainly unusual. Let me speculate a bit - and let me stress speculate - on causes and consequences.

1. Part of it was probably just a series of mistakes, either unforced or, most likely, forced by the context of the Troika evaluation, inter-coalition relations, and government coordination problems. The measure was announced without any background studies legitimating it or documents explaining it in detail, leading the media to engage for days in wild and contradictory guesses about its consequences (the only study of the impact of this specific measure I know of was made by a group of economists of Minho and Coimbra). The government even failed to ensure that, in the immediate aftermath of the announcement, at least a few voices would come in its defense, either from within the PSD or (especially) from the coalition party, the CDS-PP. Instead, what it got was a barrage of criticism not only from the opposition but also from notable figures of the PSD and from its coalition partner. It is difficult to recall a single respected political figure, scholar, or expert that came in the measure's defense. In reaction to this, the government kept introducing nuances to the measure that seemed to be made up as it went along. From the political marketing/communication point of view, the whole thing was abysmally managed. Voters may have difficulties in understanding the implications of these sorts of measures beyond the very evident fact that their paycheck will be smaller, but they have no difficulty in looking around for cues from reliable sources in order to form their opinions. And so they did: a week later, 78% of respondents in a public opinion poll disagreed with the notion that the reduction of
companies' social security contributions would help fighting
unemployment, while 81% disagreed with the notion this would have an
impact on consumer prices. Game over.

2. There was probably also some amount of hubris involved. It may be the case that some people in the government or in the group of government advisers are persuaded that the 2011 election and the PSD's victory meant some sort of vindication of a "liberal," "market-friendly," or "business-friendly" agenda. If that's the case, I'm afraid they are likely to be sorely mistaken. The data from the 2011 post-election study shows that voters' positions in these issues have remain unchanged since at least the early 2000s, and that such positions were furthermore completely irrelevant in their vote choices. This means that the PS's effort to turn the election into an ideological "fight for the survival of the welfare state" was a failure, but also that the election did not mean in any way a legitimation of the PSD's ideological agenda either. Furthermore, anyone who has ever looked at surveys measuring Portuguese voters' views about social inequality and work relations would easily guess that any measure that could be construed as "shifting money from workers to employers" would have close to zero chances of eliciting any sort of relevant support.

3. We should not forget that the government's problems did not start in September 7th. The government had a horrible summer, most notably a media barrage against minister Miguel Relvas and his alleged ethical and legal problems. Then, the plan for privatization of public television - led precisely by Relvas - managed to mobilize an influential sector of opinion - cultural and media agents - that are not exactly known for their love of the Right. A lot of badly needed political capital was wasted on these side issues.

4. There's also an element of the government's discourse since the very beginning that is probably counterproductive. The vaguely populist message entailed in the "smallest government ever" thing and on the emphasis on "fighting waste" and "trimming the fat" in the state apparatus, together with regular and ill-advised promises that economic recovery is coming "next year", probably did not help making voters quite prepared for real magnitude of the problems faced, for the failures in meeting the deficit targets, and for the many additional austerity measures that will be necessary in order to meet them. Correct management of expectations is much more important that giving false "glimmers of hope" or pretending that "trimming fat" is what this whole thing is about. We're in this for the long haul, and everybody hates realizing they may have been deceived.

5. The future holds dangers. I leave the economic dimension to my colleagues here, but it seems clear that the marriage between the PSD and and CDS-PP is becoming more and more a marriage of convenience, plagued by mutual distrust. Minister Relvas has been mortally wounded for a few months now, but it is unclear who is supposed to perform his political coordination role when (we're way past the "if" question) he ends up being replaced. It is also a bit of a mystery how Mota Soares, the CDS-PP social security minister, who supported the TSU measure only to face his own party's leader disagreement a few days later, finds it appropriate to remain in the cabinet. Some of these problems can be solved with a cabinet reshuffle after the approval of the 2013 budget, but the legacy of mistrust between the parties and the way the "governability" image of Portugal was tarnished will be difficult to reverse.

6. But not all is bad news. There's no obvious alternative political solution to the current coalition. Most voters seem to agree with that. The somewhat unpopular President, Cavaco Silva, played nonetheless a crucial role in defusing the crisis brought about by the TSU measure. The fact that the government was able and willing to back down from the TSU measure is a very positive sign. Demonstrations have been large and reveal anger and disappointment, but they have been peaceful, and so have the relations with police forces. The Minister of Finance's comments about the demonstrations, praising their moderation and dignity, were impeccable. The contrast with Spain, not to mention Greece, is quite instructive. Robert Fishman, a political sociologist, has a wonderful article in which, among other things, he shows stark and unexpected contrasts between Portugal and Spain in what concerns the relationship between protesters and institutional power holders and the role and acceptance of mass mobilization in Portugal. The recent events are a nice confirmation of Robert's ideas.

Tuesday, 25 September 2012

Mind you, the U-turn by the Portuguese Government reveals more about its internal functioning than about its determination to proceed with the Memorandum agenda. The proposed changes in the Social Security Contributions (TSU) were designed by a small inner circle of a couple of cabinet members and a few other government advisors, and they were made under the impression that public opinion and opinion polls didn't matter. Certainly that the Prime Minister was aware of what was going on, but he did not pay enough attention to the true extent of the proposed measure as he notably trusted those in charge for the plan. The U-turn has to be analyzed in that context. The proposed measure - which would have implied a direct income transfer from employees to employers - was indeed outrageous. The way the Government is doing its business didn't allow for the necessary political control. There is no need now to put further pressure on the Portuguese Government so that it proves its willingness to proceed with the troika Memorandum - for the sake of the Portuguese public. What we need now is pressure on the Government so that it pays more attention to the fact that too much austerity is counterproductive, as the IMF and other institutions have been saying for more than a year now. PS: an excellent follow-up.

From 1995 to 2001 the large decrease in nominal interest rate (panel 1) fueled an expansion in private expenditure (panel 2) financed with debt (panel 3) while the increase in demand pushed nominal labor compensation to ran a rate of 6 percent per annum, a rate well above labor productivity, and GDP inflation to increase to 4 percent per annum. The result was a large and rapid loss in competitiveness vis-a-vis the eurozone partners (panel 4). During and after the recession of 2002, labor compensation and final prices inflation decelerated, but not sufficiently, and Portugal competitiveness continued to, this time slowly, deteriorate against the other eurozone members (panel 4). (click to enlarge)

Competitiveness

A measure of REER based on ULC vis-a-vis the rest of the eurozone, normalized to 100 in 1995, was at 83.4 in the the fourth quarter 2011 implying a cumulative loss of 16.6 pp. A similar measure based on GDP deflators was at 88.3 implying a cumulative loss of 11.8 pp.

Consequences ?

The observation that the real exchange rates remained misaligned so persistently (the GDP deflator REER moved very little since the starting of the euro) leads to the following question: will the REER have to adjust back to the 1995 level or even overshoot to remedy the accumulated consequences of overvaluation? One argument for overshooting is that the accumulation of net external debt means that the current account cannot be balanced simply by returning to the initial real exchange rate. Now there is a deficit stemming from the increased debt service (and much lower remittances). Therefore, to restore current account balance, an over-depreciation might be required. However not every model/economist agrees on the necessity of the REER adjustment. Another old dispute.

P.S.
One has to remark that last year current account adjustment has been extraordinary and mainly driven by net exports. An interesting question is to explain how this improvement occurred.

Sunday, 23 September 2012

As I wrote in my last weekly column in Dinheiro Vivo, the government of Mr. Passos Coelho just went through its "poll tax" moment. As Mrs. Thatcher, more than twenty years ago, the government tried to implement an economic policy that (i) makes sense in some simple models of the economy, (ii) but has ambiguous effects once you change a few assumptions, (iii) was not progressive and because of that was politically toxic, (iv) led to widespread social protest, (v) and turned part of his own party and coalition against him.

Unlike Mrs. T, Mr. Passos Coelho seems to have been wise enough to move back before it was too late. Whether one agrees with the economic merits of the measure or not, kudos to him for stepping back from the trap that the great Mrs. Thatcher fell right into. Only time will show what the long-run consequences of this mis-step will be.

Wednesday, 19 September 2012

My previous post raised the question of whether the highest marginal taxes apply to income brackets which are not too high. Increasing these marginal taxes could then penalize the middle class. Two comments: firstly, my claim for increased progressivity obviously includes changing both the marginal tax rates and the income brackets to which they apply, if needed. Secondly, the highest marginal tax rates actually apply to relatively high incomes. The standard way in which the OECD measures this feature of the tax system is the ratio between the lowest income value to which the top marginal tax rate applies and the average wage of the country. In Portugal, this figure amounts to 9.7, as of 2010. Only Chile has a higher score than Portugal in this regard. The differences between the Personal Income Tax schedule applied in 2010 and 2011 are too small to change this figure significantly.

Source: OECD, Taxing Wages, 2012

Let me stress that this is a rather partial view on progressivity. A tax reform aimed at increasing progressivity may use both the definition of the income brackets and the marginal tax rates applying to each of them.

Monday, 17 September 2012

Suppose that the proposed changes in the Social Security Contribution are a success, namely, that prices go down, investment goes up, unemployment goes down and global external competitiveness increases, all by large margins. Portugal would provide a new view for economic policy for the whole world, and fully confirm the theoretical approaches developed in the last decade or so. We would have visits from economists and politicians to study locally the phenomenon. But... If that happens, what would stop Spain from taking the same measure? And then France, and then Italy... Maybe the final outcome would be some sort of European wage union, replicating the euro, which was created, among other things, to stop competitive devaluations... The fact that no one is really worried about this form of competitive devaluation, however, may be a good indicator of its potential.

Sunday, 16 September 2012

The announcement of a policy increasing the social security contribution of workers with a reduction in employers' contribution was the spark that lead to a strong street demonstration Saturday 15th. The demonstration was already called for but the announcement of the new measures did put people on the street.

The complain was obviously the perceived unfairness of shifting money from workers to employers, and more broadly the austerity imposed by the financial rescue plan. Still, this simple view may be misleading. The demonstration was shared by several cities in Portugal, people interviewed were basically expressing the concern about the road taken by the Government with this specific policy. In the end, despite some fear it was a peaceful demonstration, gathering people from different ages and political views. More tense images from the demonstration walking by the IMF delegation in Lisboa can be somewhat misleading about the general feeling of the population, at least for now.

We need and should discuss the direct economic implications of this policy (see the posts of Susana Peralta and Francesco Franco on this). Still, there is another sort of impact and in a sense a deeper one that may have implications for economic activity.

The demonstration was a clear call for the government to review the latest measure on social security contributions. Whatever the end result, whether the policy measure will be carried out as proposed, or modified or even dropped, there is the risk of this week events having an impact on the ability to introduced further reforms in the public sector, in the labour market, in the housing market, etc...

The necessary goodwill among social partners has been damaged to some extent, and there will be need to rebuilt trust between the government and the social partners, and between government and the population at large.

Also the impact on effort and willingness of people to move forward may be affected. Long term solutions for the portuguese economy have to involve development of new products and services, provide services and goods with high quality, and so on. But the commitment of workers to make more effort to develop new products, to increase productivity in current tasks, and even to smile when providing a service to the tourist may be at risk. Thus, the discussion on productivity gains needs to regain a central role - how does a policy proposal contribute to increase productivity? how fast and how much?

Ricardo Reis has suggested increasing the progressivity of the personal income tax as a means to raise more revenue and tackle the budget problem (may be read here, in Portuguese). There are several good reasons for the government to take this suggestion seriously. As Ricardo himself writes, the labor supply elasticity of top income earners with respect to marginal tax rates is empirically lower than what is generally accepted in the political debate. This recent paper surveys the empirical literature on the estimation of tax elasticities and concludes that there is room to increase tax revenue by increasing the marginal tax rates of top income earners.

The elasticity may stem from four types of behavioral responses to tax rates which lead to a change in reported income following a tax reform. The first one is decreasing labor supply, the second is tax evasion and the third one is income shifting (i.e., shifting part of one's taxable income to corporate income tax by means of more or less complicated, albeit legal, administrative and accounting procedures). The fourth one is a bargaining channel - top income earners usually have decision power over the wages they offer themselves and may simply allocate a greater share of firms' profits to their own compensation packages. Their incentive to do so is obviously lower if they are subject to higher marginal tax rates.

The first channel is the only one which entails an efficiency cost. The second may be tackled by improving the tax administration competences and monitoring capacities. The third channel, in turn, implies that fiscal revenue will increase
elsewhere, e.g., in corporate income tax (although in principle the
total fiscal revenue decreases). Hence, if anything, the elasticities of reported income with respect to
the income tax rate, which range between 0.12 and 0.4 are an upper bound
on the actual efficiency cost of taxation. For instance, an elasticity
of taxable income of 0.4 implies that a 1% increase in the tax rate
decreases taxable income by 40%. Let's make this clear: an increase in
the tax rate will only decrease tax revenue if this elasticity is higher
than 1 - that is far from being the case.

The fourth channel is particularly appealing in the actual context of increasing inequality and economic crisis, because it entails a zero-sum transfer of resources from bottom to top income earners. This other paper suggests that this latter is the most important determinant of the elasticity of taxable income of top income earners, building a case for high marginal taxes on top incomes as a means to decrease the incentive of managers to offer themselves a larger share of the pie.

How does Portugal compare to the remaining OECD countries in the way it taxes top income earners? The Figure taken from this paper shows that it scores relatively low in this regard.

Source: Piketty, Saez and Stantcheva, "Optimal Taxation of Top Labor Incomes: a Tale of Three Elasticities", CEPR 2011.

And what about the efficiency consequences of increasing it? They are likely to be limited, as discussed above, and because there is no apparent link between changes in marginal tax rates of top income earners and GDP growth.

Source: Piketty, Saez and Stantcheva, "Optimal Taxation of Top Labor Incomes: a Tale of Three Elasticities", CEPR 2011.

With the current erosion in the political consensus around the rescue package in Portugal, this is interesting food for thought.